In the beginning, there weren't exactly a wealth of options for
investors seeking alternative weighting methodologies beyond the
gold standard, market cap-weighting. This process, which gives the
largest weights to the biggest companies, has grown to dominate the
market for a few reasons. First, market cap-weighting tends to be
easy to maintain and requires little in terms of rebalancing. Firms
such as ExxonMobil or General Electric seem destined to always be
giant companies meaning that funds can count on these companies to
always make up large chunks of a cap-weighted portfolio.
Additionally, for large funds, it is very easy to trade in big
stocks such as Exxon and other large caps, as the volume for these
securities is immense. This is in stark contrast to some smaller
names which cannot rival the deep liquidity offered by the stocks
that are on the DJIA or other mega corporations. Thanks to these
factors, as well as the popularity of and ubiquitous nature of
cap-weighted indexes such as the S&P 500, the method remains by
far the most popular choice for ETFs as well.
However, the golden age of cap-weighting appears to be ending as
there are a number of other techniques which are gaining a cult
following among many investors. These relatively new methods seek
to break the link between stock price and weight, potentially
giving investors a better way to play markets. This is because many
believe that cap weighting is fundamentally flawed as the technique
overweights overvalued securities and underweights undervalued
securities putting investors at a disadvantage over the long
haul.
In light of this, a number of issuers have staked their claim in
the 'alternative weighting' space, seeking to build a suite of
products that have a particular methodology. Below, we highlight
some of the most popular alternatives to market cap-weighted
products, highlighting some of the pros and cons to each method as
well as some of the issuers that employ these techniques. While no
method is universally superior to cap weighting or to the other
alternative weighting methodologies, it is very important to know
what kind of markets these funds may outperform (or underperform)
in and what their own biases are in their portfolios.
Earnings
If an investor is seeking to avoid risky, unprofitable
companies, the earnings-weighted methodology could be the way to
go. This technique screens out companies that are losing money and
then adds up all the earnings in the component group and gives each
company their proportionate share of the aggregate earnings as
their weight in the fund. This gives investors exposure to a basket
of lower risk stocks that can reduce overall volatility. The fund
also focused in on 'core earnings' so investors can rest assured
that one-time earnings boosts and asset sales do not overtly impact
the weightings of the product. Currently, earnings-weighting is
used by WisdomTree and their suite of ETFs. The company has six
ETFs using earnings-weighting focused on the U.S. as well as a few
others in the international space, primarily the WisdomTree India
Earnings ETF (
EPI
).
While this strategy may sound intriguing, investors should be
aware of a few limitations. An earnings focus can often overweight
a portfolio towards value stocks making any funds based on this
idea likely to outperform in down markets and underperform in bull
markets. From a sector perspective, companies with big profit
margins (financials, health care) tend to be at the top while low
profit margin businesses (utilities, materials, telecoms) tend to
stay near the bottom. This is likely because these high profit
margin firms have an easier time generating earnings and thus can
make up bigger weightings in a particular earnings-weighted
fund.
Dividends
For income focused investors, using dividend weighting can be an
intriguing alternative. Funds using this technique only include
companies that pay cash dividends and weight the portfolio by the
dollar value of this metric that is paid out to investors. This
could be an interesting choice that may give a portfolio a value
tilt with a higher yielding focus. Furthermore, investors may also
like that the fund can avoid some of the worst offenders on a
corporate governance and earnings quality front as cold hard cash
payouts to investors are pretty hard to fake. Dividend-weighting is
used primarily by WisdomTree; the firm has six U.S. focused
dividend ETFs and a few international dividend-weighted products as
well.
However, investors should note that this method can have its own
biases, especially in terms of sector allocations. Funds in this
space tend to offer up healthy allocations to companies in the
consumer, health care, and energy spaces, while materials and tech
tend to make up smaller chunks of the portfolio. Also, it is
important to remember that these products are weighted by total
cash dividends paid and not yield. This is an important distinction
that leads to a lower yield than what many investors are likely
expecting for a product focused on dividend payers. In fact, the
WisdomTree LargeCap Dividend Fund (
DLN
) offered up a yield of 3.1% at time of writing.
Revenue
For those investors who are focused on the top line, a
revenue-weighted ETF could be worth a closer look. This tactic
ranks all component securities by top line revenues giving the
biggest weights to companies that do the most sales. This could be
an intriguing choice for investors who do not like the exclusivity
of the dividend or earnings model since while every company may not
have either of these items, they all have revenues. Currently,
there are six ETFs that use a revenue-weighted methodology, all of
which are from upstart firm RevenueShares. The company has products
targeting large cap, mid cap, and small caps and also has a
financials focused fund (
RWW
) as well as an ADR product (
RTR
) for those seeking international exposure.
While this method intuitively makes sense-more sales equals more
weight--- there are still issues with this strategy as well. First
off, investors should note that it can be overweight in low margin
businesses such as retail, consumer banking, and consumer staples.
Meanwhile, on the underweight side, the fund is relatively light,
when compared to the S&P 500 in technology, one of the highest
margin segments of the economy. This is often because firms in low
margin businesses generally need to sell more in order to be as big
as their peers in more lucrative industries. For example, Target
has roughly the same amount of sales as Microsoft but in terms of
gross profit, Microsoft has close to twice Target's figure. Thanks
to this, TGT receives a slightly higher weighting in RWL than
Microsoft despite the fact that MSFT has a market cap nearly six
times TGT.
Equal
Another approach to the weighting question is via equal levels
for each component security. This style allocates the same
percentage to each company in a benchmark no matter how big or
small or how much it has in earnings, dividends, or any other
metric. This can result in diversification away from large cap
focused funds that are often tilted heavily towards the giants in a
particular sector. These funds are also regularly rebalanced back
to equal weight which helps to take profits on outperforming
components of the index. Those proceeds can then be reinvested in
out-of-favor components, resulting in equal and unbiased exposure
to the index constituents, a situation that may help investors who
aren't disciplined when it comes to selling.
In terms of companies that offer funds following this idea, the
space isn't exclusive to any one firm. With that being said, Rydex
definitely leads the way on the equal weight front, offering the
most out of any single issuer. The company has equal weight
products targeting all of the U.S. sectors as well as ETFs for
large, mid, and small cap exposure as well. Lastly, the company
also has a few equal weight products in the international market,
giving investors the ability to build an entire equity portfolio
with equally-weighted ETFs.
Equal weighting's flaws, unlike many of the other product
classes on this list, do not really stretch into sectors too much.
With that being said, there are some biases towards sectors where
there are a lot of firms-such as financials or tech-and away from
the spaces where only a few firms exist, such as utilities,
telecom, or materials. Instead, these funds can often be overweight
in volatile small cap securities and can thus underperform when
investors are fleeing risky assets. So while the S&P 500 equal
weight fund RSP has outperformed SPY in the past, with a shaky
market environment it underperforms and can fall behind.
Fundamental
Beyond the alternatives outlined above, investors also have a
number of options that take a more 'fundamental' approach to
investing. These techniques use a metric or a variety of data
points in order to determine weighting levels making funds that
follow this strategy unlike any of the others outlined above. For
investors seeking to learn more about this investing style,
consider these three tactics:
-
RAFI-
This style, which stands for Research Affiliates Fundamental
Index, involves selecting and weighting securities by fundamental
measures of company size, as opposed to market capitalization.
This involves using barometers such as company sales, profits and
dividends and coming up with weights based on a multifactor
approach. This strategy can also break the link between price and
weight but a look at a portfolio based on this methodology can
lead to similar top holdings as cap-weighted funds (although the
weights are by no means identical).
-
FirstTrust AlphaDEX-
AlphaDEX seeks to rank stocks on growth and value factors and
then only give weights to the best companies in each ranking. In
fact, the securities that rank in the bottom 25% are eliminated
from the portfolio while the remaining stocks are divided into
quintiles based on their rankings. Then, weights are assigned to
each quintile with the most going to the top quintile and
stretching lower, although within each quintile stocks are
equally-weighted. This could result in a portfolio that could
outperform, especially if the company's weighting strategy only
invests in the best companies as it hopes to do. The main
downside to this strategy is the expense; fees can often run
around the 0.7% mark, a level that can be-depending on the asset
class-much more expensive than low cost options in the space or
even other alternative styles.
-
Russell Factor ETFs-
These ETFs which use a factor such as momentum, volatility, or
beta, give investors yet another option for an alternative to
market cap weighting. In this method, companies that have the
highest metric-such as volatility-are given the highest
weighting. While this does help to produce a portfolio different
than a cap-weighted fund, it can lead to concentration in a
particular sector. For example, the firm's high beta ETFs are
tilted towards durable goods and tech companies while the low
volatility fund has heavy weights in consumer staples and
utilities.
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